1. 20 Short-Term Financing Chapter
See c20.xls for spreadsheets to accompany this chapter.
South-Western/Thomson Learning © 2003

2. Chapter Objectives To explain why MNCs consider foreign financing;
To explain how MNCs determine whether to use foreign financing; and
To illustrate the possible benefits of financing with a portfolio of currencies.

3. Sources of Short-Term Financing
Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks.
MNCs may also issue Euro-commercial papers to obtain short-term financing.
MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.

4. Internal Financing by MNCs
Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available.
Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.

5. Why MNCs Consider Foreign Financing
An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency.
An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.

6. Short-Term Interest Rates
U.K.
Japan
Canada
Germany
U.S.

7. Determining the Effective Financing Rate
The actual cost of financing depends on
the interest rate on the loan, and
the movement in the value of the borrowed currency over the life of the loan.

8. Determining the Effective Financing Rate
1. Borrows NZ$1,000,000 at 8.00%
for 1 year
At time t
3. Has to pay back NZ$1,080,000
1 year later
2. Converts to $500,000
Exchange rate = $0.50/NZ$
4. Converts to $648,000
Exchange rate = $0.60/NZ$
What is the effective financing rate?
$648k – $500k = 29.6%
$500k

9. Determining the Effective Financing Rate
Effective financing rate, rf
= {( 1 + if )  St+1} – {1  St} = ( 1 + if )St+1 – 1
{1  St} St
where if = the interest rate on the loan
St = beginning spot rate
St+1 = ending spot rate
The effective rate can be rewritten as
rf = ( 1 + if ) ( 1 + ef ) – 1
where ef = the % D in the spot rate

10. Online Application
Current interest rates and exchange rates are available at
Interest rate and exchange rate forecasts can be found at

11. Criteria Considered for Foreign Financing
There are various criteria an MNC must consider in its financing decision, including
interest rate parity,
the forward rate as a forecast, and
exchange rate forecasts.

12. Criteria Considered for Foreign Financing
Interest Rate Parity (IRP)
If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

13. Implications of IRP for Financing
holds?
Financing
costs*
Type of
financing
* as compared to the financing costs for domestic financing
Scenario
Yes
Covered
Similar
Forward rate accurately
predicts future spot rate
Yes
Uncovered
Similar
Forward rate over-
estimates future spot rate
Yes
Uncovered
Lower
Forward rate under-
estimates future spot rate
Yes
Uncovered
Higher
Forward premium(discount)
exceeds (is less than)
interest rate differential No
Covered
Higher
Forward premium (discount)
is less than (exceeds)
interest rate differential No
Covered
Lower

14. Criteria Considered for Foreign Financing
The Forward Rate as a Forecast
If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate.

15. Criteria Considered for Foreign Financing
Exchange Rate Forecasts
Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates.
Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates.

16. Actual Results From Foreign Financing
The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

17. Financing with Yens versus Dollars
Annualized interest rates (%)
US$/100¥
U.S.
Effective rate
$/100¥
Japan

18. Financing with a Portfolio of Currencies
While foreign financing can result in significantly lower financing costs, the variance in the costs is higher.
MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

19. Financing with a Portfolio of Currencies
If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously.
Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

20. Financing with a Portfolio of Currencies
A firm that repeatedly finances in a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis.
When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

21. Financing with a Portfolio of Currencies
For a two-currency portfolio,
E(rP) = wAE(rA) + wBE(rB)
where rP = the effective financing rate of the portfolio
rX = the effective financing rate of currency X
wX = the % of total funds financed from currency X

22. Financing with a Portfolio of Currencies
For a two-currency portfolio,
Var(rP) = wA2A2 + wB2B2 + 2wAwBABCORRAB
X2 = the variance of currency X’s effective financing rate
CORRAB = the correlation coefficient of the two currencies’ effective finance rates

23. Impact of Short-Term Financing Decisions on an MNC’s Value
E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Expenses Incurred from Short-Term Financing

24. Chapter Review Sources of Short-Term Financing Euronotes
Euro-Commercial Paper
Eurobank Loans
Internal Financing by MNCs
Why MNCs Consider Foreign Financing
Foreign Financing to Offset Foreign Receivables
Foreign Financing to Reduce Costs

25. Chapter Review Determining the Effective Financing Rate
Criteria Considered for Foreign Financing
Interest Rate Parity
The Forward Rate as a Forecast
Exchange Rate Forecasts
Actual Results From Foreign Financing

26. Chapter Review Financing with a Portfolio of Currencies
Portfolio Diversification Effects
Repeated Financing with a Currency Portfolio
Impact of Short-Term Financing Decisions on an MNC’s Value